International Finance Theory and Problems
International Finance Theory and Problems ECON 3633
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Class questions April 25 2006 Lecture 24 ECON3633 900 Reading assignment Chapter 4 Melvin pages 72 76 Chapter 9 Eun and Resnick supplemental l Swap contracts a De ne a swap contract A swap contract is a combination of a forward contract and a spot contract Typically a trader in need of foreign currency for a fixed period of time will be matched with a foreign trader in need of domestic currency for the same period An intermediary will bring the two entities together Each trader will borrow in their domestic country exchange currency with the party in the other country through a spot contract and reverse the transaction in the future through a forward contract b De ne a basis point A basis point is defined as 1100 11 of a percent or 0 0001 c Consider the market for euros Suppose the current spot rate for is 125 Suppose the 1 year forward rate for is 130 Calculate the number of basis points for this example First we calculate the di erence between the forward rate and the spot rate 130 125005 This is equal to 500 basis basis eg 50000001005 2 List 5 ways in which a futures contract differs from a forward contract a A futures contract is typically bought and sold on a centralized exchange the most prominent example being the Chicago Mercantile Exchange In contrast virtually all forward contracts occur between an individual bank and their client known as over the counter or OTC In this way the futures contract is typically less flexible than a forward contract b A futures contract that is bought or sold on a centralized exchange is only available in a limited number of currencies In the case of the CME trade only occurs for the Japanese yen the Canadian dollar the British pound the Swiss franc the Australian dollar the Mexican peso the euro and the US dollar In contrast a forward contract can be negotiated for exchange between any two currencies the two parties agree to O A futures contract bought and sold on the CME is only available is fixed lots In particular one can buy or sell a futures contract in the following denominations I25 million C 100000 62500 CHF 125000 A I 00 000 Peso 500000 I 25 000 Again because trade in the forward market is far more idiosyncratic trade can occur for any amount of foreign currency the traders agree to 9 A futures contract in the CME will only mature on a specific date In particular futures contract typically exist for delivery in March June September and December These contracts mature on the third Wednesday of the respective month In stark contrast a forward contract can be written such that delivery of currency occurs on any date agreed upon by the two parties D To purchase or sell a futures contract the trader must establish an initial margin which acts as collateral As the value of the contract changes the margin is settled at the end of each day based on the price at the end of the day known as the settlement price If a trader has purchased a futures contract then money is added to the margin as the value of the contract increases while money is subtracted from the margin account if the value of the contract falls Just the opposite occurs if we sell a futures contract If enough money is subtracted from the margin account eventually a margin call will ensue in which case the trader is asked to supply additional collateral Such margin calls are not present in the case of a forward contract This particular aspect of a futures contract in addition to the fact that the contracts are not as flexi ble makes the futures contract more attractive from a speculation point of view than from a hedging point of view Lecture 20 ECON 3633900 April 11 2006 Reading assignment Chapter 5 Melvin Chapter 5 Eun and Resnick 101104 Class questions 1 De ne covered interest rate parity Speci cally define any notation you use Suppose there are two countries a domestic country and a foreign country Further suppose that exchange rates are quoted as units of domestic currency per foreign currency Covered interest rate parity states the percentage forward premium on the foreign currency is equal to the di erence between the domestic and foreign interest rates standardized by 1 plus the foreign country s interest rate Mathematically define the following F 39 forward rate maturing inM months S39 current spot rate i39 annualized interest rate on an asset maturing in the domestic country inM months i39 annualized interest rate on an asset maturing in the foreign country inM months First we standardize the interest rates appropriately We have 71 M 12 2 12 M M It 12 E Then CIRP states E is Hquot 2 a Suppose you are given the following information Flt gt3 months 12194 Sf 1 2124 i0 10 the annualized 3 month Tbill rate in the Us i 004 the annualized 3 month Tbill rate in Germany Is there a covered interest arbitrage opportunity Explain First note that it is necessary to convert the annualized interest rates into quarterly interest rates We have e 010 12 0025 M 004 i T001 Now let s compare the following quantities N M F 1 it versus 1 it S We have 12194 12124 N M F 1 110251025 and 11 S 101 101583 2 Since these di er I know that there is an arbitrage opportunity We have N M F 14 gt 11 St This tells us that N S M 1 39 gt 1 39 12 E It This implies that I can borrow money in the foreign country and lend it in the domestic country My return in foreign currency units exceeds the amount I must pay back Class questions April 27 2006 Lecture 25 ECON3633 900 Reading assignment 1 Chapter 4 Melvin pages 72 76 Chapter 9 Eun anal Resnick supplemental Refer to the handout from the Wall Street Journal which lists the value of futures contracts for foreign currency as of April 24 2006 Consider a contract for delivery of in June Suppose we wish to buy such a contract we could sell one but here we buy one Note that this implies that we are long in foreign currency Presume that we buy the contract at the start of the day a Fquot 0 What is the lowest price the contract traded at throughout the course of the day How about the highest As the hanalout illustrates the lowest price for the December contract in euros is 122 74 while the highestprice is 12410 The low pricefor the life of the contract was 11 798 In contrast the highest price over the life of the contract was 13 795 What was the settlement price for this contract on April 24 How much is added or subtracted from the margin account for that day The settlement price for the June contract was 1 23 61 Relative to the start of the day when we purchased the contract the price has increased This represents a positive change in the value of the contract In the case since we have one contract 12361 12302 125 000 73750 is added to the margin account Notice that this particular contract matures on June 21 of this year Recall that by definition the settlement price at the minute the contract matures is exactly the spot rate at that moment Suppose that on June 21 at the time the contract matures the dollar price of the is 12765 Over the life of the contract how much has been added or subtracted from the trader s margin account The final settlement price will be 12765 while we purchased the contract at 1 23 02 Since the settlement price exceeds the price at which the contract is purchased money is added to the margin account In this case 12765 12302 125 000 5 78750 is added d How much will the trader have to pay on June 21 if they actually wish to take delivery of euros The final settlement price is 12765 Thus the trader must pay 12765 125 000 15956250 5 Taking into account any money added or subtracted from the margin account what is the total amount the trader will have to pay if they actually wish to take delivery of 125000 in June What is the signi cance of this amount relative to the open price when we purchased the contract The total cost to the trader is the amount they have to pay for delivery of euros net the amount added to the margin account In this case we Pay 15956250 578750 15337500 Note that the open price in April when we purchased the contract was 1 23 02 1 f we locked in that price in a manner similar to forward contract we wouldpay 12302 125 000 153375 00 Thus the final amount we pay is given by the price on the date we purchased the futures contract Lecture 22 ECON 3633900 April 18 2006 Reading assignment Chapter 5 Melvin Chapter 5 Eun and Resnick 101104 Class question 1 List any reasons why covered interest rate parity may not hold The following are potential reasons as discussed by the Melvin textbook a The examples we have looked at ignore transactions costs including the bid ask spread on both exchange rate transactions and bond transactions b In some instances there are di erential taxes on capital gains c Some countries may have government controls such as capital controls Clearly this applies more to less developed countries d There may be some inherent political risk for example the environment surrounding the Argentine peso crisis Of course as we have discussed if transactions costs are taken into consideration and ifwe confine our attention to mainly developed countries then we can largely treat covered interest rate parity as an identity that is expected to hold 2 Suppose that you are given the following information concerning the market for pounds s5 210 Sew ma 200 expected spot rate in one year F5 31wa 205 a Calculate the percentage risk premium and indicate whether the dollar or pound is riskier The riskpremium is given simply by E 7 SEW 7 205 7 200 S 7 210 Since the risk premium is positive we know that the dollar is perceived as relatively risky 0024 b Suppose the annualized one year interest rate in the United States is 010 while the interest rate in the United Kingdom is 0124 Compare the rate of return from investing 1 in the United States versus the expected rate of return from investing 1 in the foreign country Suppose that any future transactions involving exchange of currency will occur using the spot market in the future as compared to the forward market Explain any differences using the risk premium The rate of return from investing 1 in the United States is simply the interest rate 010 The expected rate of return from investing 1 in the United Kingdom is given by 53 S 175 0124 55200755210 S 210 00764 The rate of return from investing 1 in the United States actually exceeds the expected rate of return from investing 1 in the foreign country This actually makes sense as the is perceived as being relatively risky Class questions January 31 2006 Lecture 4 ECON3633 900 1 The balance of payments current account a De ne the balance of payments Fquot The balance of payments is a double entry bookkeeping system that records a country s international transactions in goods services and financial assets The balance of payments includes transactions in both the current account and capital account which includes of cial reserve transactions List the four categories af liated with the current account For each use the numbers in the Melvin textbook eg from the handout given in class to determine whether these subcomponents have been in a surplus or a de cit recently in the United States The four categories of the current account are 1 Merchandise trade huge deficit since the early 1980 s The Melvin textbook suggests that the merchandise trade balance in the US in 2000 was 452 billion Services Generally the US has a surplus in this category According to the Melvin textbook the US had a surplus of 73 742 billion in 2000 Investment income Has uctuated around 0 sometimes being positive and sometimes being negative In 2000 according to Melvin the US had a surplus of2I 782 billion Unilateral transfers This account has chronically been in deficit as the US provides more aid to the rest of the world than the rest of the world provides to the US According to Melvin the US had a balance of 53442 billion in 2000 N 5 e 2 The balance of payments the nancial account a There is some disagreement about whether or not of cial reserves should be included as a direct category of the nancial capital account Excluding this particular account list and de ne the three main components of the capital account 1 Foreign direct investment Investment in a company involving a foreign entity where the foreign entity owns a substantial portion of the company In the US a substantial portion occurs if the foreign entity owns at least 10 of the company 2 Security purchases Private sector purchasessales of equity and debt securities by a foreign party that does not involve a substantial transfer of ownership see above 3 Other investment Foreign investment transactions that include trade in currency bank deposits etc b Suppose there are no statistical errors in constructing the balance of payments If the current account is in a deficit what must be true of the capital account By definition a current account deficit implies a capital account surplus 0 What is the rule that we use in determining whether or not to credit debit a capitalfinancial account transaction We credit treat as a positive entry any transaction in the CAPITAL ACCOUNT ONLY ifit increases liabilities or decreases assets We debit treat as a negative entry any transaction in the CAPITAL ACCOUNT ONLY if it decreases liabilities or increases assets 3 Classifying balance of payment transactions Classify the following transactions in the US current account i Your professor travels to Amsterdam and spends 10000 during his Visit He pays using euros he purchased directly with dollars Debit 1 0 000 services in the current account traveling abroad is tourism When we travel to another country it is considered to be a tourism import MercedesBenz sells 400000 of its car to a US distributor allowing 90 days credit until payment is due Debit 400 000 merchandise trade in the current account here the US distributor imports a tangible commodity the cars from a German company iii Benjamin Fronz a Swiss citizen sends his grandson in the Us 300 a Christmas gift Debit 300 other investment in the capital account the grandson has an increase in their assets The transaction falls under the category of other investment since it involves trade in currency You purchase stock in a Belgian company for the equivalent of 250000 Only the capital account is a ected There are no current account components to this transaction January 19 2006 Name Lecture 1 ECON 3633900 Please refer to the handout which contains exchange rate quotes as of January 17 2006 1 Consider the direct dollar quote for euros on Tuesday January 17 2006 a Find the indirect quote mathematically without using the tables The direct quotation for euros is 12105 Then the indirect quotation the euro price of the dollar is given by S 1 12105 8 08261 b Relative to Tuesday has the Euro appreciated or depreciated Explain The direct quotation from the euro perspective is the indirect quotation from the US perspective Recall that the direct quotation from the perspective of the euro relative to the dollar is the euro price of the dollar In this case we see the direct quotation for the euro has risen from 08248 to 60 8261 In this case the euro has degreciated C From the US perspective write down the direct quote for the Australian dollar Again from the US perspective write down the indirect quote for the Japanese yen Use these quotes to nd the Australian dollar price of the Japanese yen The direct quotation for the Australian dollar is 0 7523 A The indirect quotationfor Japanese yen is 1 15 43 We wish to calculate SA Do we multiply or divide the quotes Suppose we multiply the quotes We have something who s unit of measure is A and we multiply by This will give us the yenprice of the A We want the Australian dollar price of the yen However as above we can simply take the reciprocal to get the Australian dollar price of the Japanese yen The result A 07523 11543 86837989 Now the Australian dollar price ofthe yen is simply 1 divided by this number SA 1S A 186 83 7989 A 001152 2 d Again using the handout and from the US perspective write down the direct quotes for the Canadian and the Brazilian real Now from the Canadian perspective use these quotes to calculate the direct quotation for Brazilian real Direct quotation C39 0860 Direct quotation Real39 0434 We wish to use these quotes to find the direct quotation from Canada s perspective of the real Do we multiply or divide If we multiply we don t get a sensible number eg C Real 2C Real If however we divide the price of the real by the price of the Canadian dollar we get exactly what we are looking for In particular Real 58 C58 C 0434108601 C 05047 1 Real Real C In the market for s suppose a trader calls a bank in Paris and gets the following quote Paris 1210010 How many dollars will the trader receive if they SELL 10000 Show your work The bid price tells us many dollars the bank will give us for each euro they buy from us Thus we receive 10000 1210012100 Class questions February 14 2006 Lecture 8 ECON3633 900 Reading assignment Chapters 3 Melvin Chapter 2 Eun and Resnick l Speculation a Fquot Suppose the quarterly interest rate in Argentina is 5 Suppose the Argentine peso price of the dollar is APs 100 and suppose Argentina has a xed exchange rate system Speculators believe that the Argentine peso is overvalued and begin to attack the peg What speci c actions will the speculator take in attacking the peg Speculators will borrow pesos in Argentina This situation is known as shorting the pesos since the investor has entered a situation where she owes currency she currently does not possess The speculator will exchange pesos for dollars in the foreign exchange market This action puts additional pressure on the peso 39 Speculators can now take one of two actions They hold dollars purchased with pesos They can purchase assets in the United States with a short maturity Alternatively they can simply hold the dollars waiting for the Argentine peso peg to dissolve When it does the dollars will buy substantially more pesos than they did prior to the end of the fix and they can use a portion of their dollar holdings to pay off their debt keeping the residual component as profit Suppose speculators believe that the peg will collapse in exactly 3 months Suppose from your actions in a that speculators decide to invest the dollars they obtained from pesos in the United States They will receive a quarterly interest rate in the US of 25 Suppose speculators are successful and that Argentina is forced to abandon the peg In 3 months the Argentine peso price of the is APs 350 Had you started by borrowing APs 100 million in Argentina exactly how much pro t would you have made Show your work i We start by borrowing APs 100 million With a quarterly interest rate of5 we will have to repayAPs 105 million three months in the future We convertAPs 100 million into dollars Given the exchange rate ofAPs 1 this yields 100 million We lend 100 million in the United Statesfor 3 months In 3 months we will receive 1025 million 100025100 iv 1n 3 months we must pay back APs 105 million 1fthe exchange rate is APs 350 at thatpoint it will cost 30 million to acquire APs 105 million eg APs 105 millionAPs 350 ii 39 Notice in this example that we keep the remaining 725 million as rofit c What defense does Argentina have in the face of an attack Once a speculative attack has occurred we can attempt to implement capital controls Alternatively and more likely Argentina can pursue an extremely aggressive contraction in the money supply thereby increasing interest rates Notice that if interest rates are substantially high it is no longer profitable to attempt to speculate 2 The Gold Standard Consider a country that has adopted a strict gold standard De ne price specie ow mechanism and use it to show what adjustment would occur if the demand for a country s exports suddenly fell while that country s demand for imports suddenly rose The price specie flow mechanism is the automatic adjustment that occurs in the balance of payments whenever gold flows in or out of a country following an international transaction under a gold standard If the demand for a country s exports fell we immediately see that the current account goes into deficit Further as the country purchases more imports we see that gold begins to leave the country Since gold is specifically tied into the money supply the money supply e ectively contracts This contraction in the money supply causes prices to fall Obviously declining prices domestically and conversely increasing prices world wide as the rest of the world s supply of gold increases causes domestic exports to increase and imports to fall Class questions February 2 2006 Lecture 5 ECON 3633 900 1 Review of triangular arbitrage Suppose you enter you are a currency trader and you observe the following currency quotes with the relevant market listed to the left Zurich CHF 1289012900 Swiss Franc per dollar New York 009550009650 Dollar per peso Mexico City CHF 011950 7 012253 Swiss Franc per peso a Fquot Use the quotes in Zurich and New York to calculate the implied Swiss franc price of the peso Note that the quote in Zurich is expressed as CHF while the quote in New York is expressed as dollars per pesos Thus we can simply multiply the bid prices in each market to get the IMPLIED Swiss franc price of the peso and similarly with the ask prices The result ImpliedBidprice 12890 0 09550 CHF 01230995 ImpliedAskprice 12900 0 09650 CHF 01244850 Is there an arbitrage opportunity If so which currency will you sell in Mexico City There is clearly as an arbitrage opportunity since the quotes do not overlap Let me start by describing the INCORRECT scenario In Mexico City we can either buy or sell pesos Suppose we try to sell them If we do so we will receive CHF 01 195 0 for each peso we sell We can indirectly buy the pesos back for CHF 0124485 0 Obviously we don t want to buy high and sell low So suppose we buy pesos in Mexico City For each peso we buy we willpay CHF 012253 We can see them indirectly for CHF 01230995 Thus we can buy pesos at a low price and sell them for a higher price Purchasing pesos in Mexico City is exactly the same as selling Swiss francs there Thus we will sell SF CHF in Mexico City c If an arbitrage opportunity exists show exactly how much profit you will make ifyou start 1000000 Our goal is to get eventually sell SF in Mexico City Thus we need to get SF We can do so immediately by exchanging dollars for SF in Zurich Here we are selling dollars to the bank in Zurich They will give us CHF 12890 for each dollar we sell them i We sell dollars in Zurich We receive 1000000 12890 CHF CHF 1289000 ii Now we have SF and can sell them for pesos in Mexico City We receive CHF 1289000 012253 CHFPeso Ps 10519872 68 iii Finally we sell pesos for in New York We receive Ps 1051987268 Ps 009550 100464784 Clearly this results in a very healthy pro t of 4 64 7 84 2 Classifying balance of payment transactions Classify the following transactions in the US current account 39 A US owned factory in the UK purchases 50000 of new machinery using local earnings ii An American buys shares of an Israeli stock for 70000 paying with a check drawn on a bank in Jerusalem iii Kuwait donates 400000 worth of oil to the United States As discussed in class the first two transactions are a bit tricky In fact the current account is not affected for either of these transactions For the last transaction we credit unilateral transfers 400 000 while we debit merchandise trade Class questions February 7 2006 Lecture 6 ECON 3633 900 Suggested Reading Chapter 2 Melvin Chapter 3 Eun and Resnick 1 The balance of payments of cial reserve account a Provide de nitions for the following 1 ii Official Settlements Balance US official reserves The of cial settlements balance is the balance on the current account plus the non of cial reserve component of the capital account In other words the of cial settlements balance is the balance of the current and capital accounts ignoring of cial reserve transactions 39 US of cial reserve transactions or US government asset transactions involve changes in US o icial reserve assets which include gold special drawing rights SDRs foreign currency holdings and reserve positions 2 Classifying balance of payment transactions Classify the following transactions in the US balance of payments current and capital account Provide the balance on the current account the capital account and the official settlement s balance i The United States donates 1000000 worth of wheat to Nicaragua The United States has given a gift We get to have good feelings about ourselves because of our kindness We are thus importing good wi ll feelings and debit unilateral transfers in the current account 1000000 Note that at the same time we are exporting wheat to Nicaragua An export of a tangible commodity would be represented as a credit to merchandise trade in the current account in the amount of 1 000 000 The Federal Reserve acquires 20000 worth 24600 in the open market in an apparent intervention move from a private citizen of France The citizen uses the s to buy a brand new Jeep Liberty from a US dealer Debit 24 600 of cial reserves in the of cial reserve component of the capital account Here an of cial government agency is acquiring euros on the open market Thus it is an of cial reserve transaction The increase in assets represents a debit to the of cial reserve component of the capital account Credit 24 600 merchandise trade in the current account A US company is exporting a tangible commodity the SUV and thus we credit merchandise trade iii An American buys shares of an Israeli stock for 70000 paying with a check drawn on a bank in Jerusalem I should have explicitly stated on the assignment that the US citizen owns less than 10 of the company in which he she is acquiring stock Debit 70 000 portfolio investment in the capital account Here the US citizen is purchasing stock and thus this falls under the category of portfolio investment We debit this account since the US citizen increases their assets Credit 70 000 other investment in the capital account The US citizen now has 70000 less in foreign assets iv A US resident receives 10000 in interest from German bonds she owns The 10000 is deposited in a German bank For the capital account always apply the rule taught in class e g debit the capital account when a transaction increases liabilities or decreases assets For the current account we credit transactions we think of exports and debit transactions we think of as imports In this case there is a return on a previous investment We recognize that this falls under the category of investment income We can think of the return on this investment as payment for a financial service the US resident has supplied In some sense the US resident exported the service of their financial capital Thus we will credit investment income in the current account 1 00001 On the other hand when we deposit the check into the German bank we have an increase in assets Thus we debit other investment in the capital account 10 000 1 Alternatively you can use another rule for the current account transactions We will credit transactions that bring currency into the country and debit transactions that result in currency owing out of the country In this case currency ows into the country and we credit investment income Below I classi v these transactions Current Account Credit Debit Merchandise Trade 1000000 1 24 600 ii Services Unilateral Transfers 1000000 1 Investment Income I 0000 iv Balance in the current account 34 600 Thus from this example the United States is running a current account surplus of 34600 Now below we consider the capital account CaQital Account Credit Debit FD Portfolio Investment 70 000 iii Other Investment 70 000 iii 10 000 iv Balance on the non of cial Reserve component of the 1 0 000 Capital Account O icial Settlement Balance 24 600 Domestic O icial Reserves 24600 ii Foreign O icial Reserves Balance in the capital account 24600 With of cial reserves Notice that of cial reserves are in de cit to offset the positive of cial settlement balance Class questions February 28 2006 Lecture 12 ECON 3633 900 1 Currency unions a Suppose the world consists of only two countries say France which produces primarily wine and Germany which produces beer Suppose that the demand for wine relative to beer increases in both countries as a result of a recent study that suggests wine may reduce the risk of a stroke i Describe what adjustment occurs if any if both countries are not part of a currency union but instead have their own national currencies and autonomy over monetary policy It is first necessary to understand what happens to the macroeconomic variables of both countries In France there is an increase in the demand for wine relative to beer causing aggregate demand to increase Output and prices both increase In contrast in Germany the demand for German goods and services declines causing output to fall and unemployment to increase With no currency union adjustment can occur both through monetary policy and the exchange rates Germany Germany can combat the recession by using expansionary monetary policy At the same time the decrease in the demand for the DM causes the DM to depreciate This depreciation decreases the costs of German goods to French citizens and thus increasesAD there The increase inAD causes output to rise and unemployment to fall These two e ects can mitigate or eliminate the recession France To combat in ation France can use contractionary monetary policy Simultaneously the French franc appreciates as the demand for the franc increases This appreciation causes a decline in aggregate demand in France since their goods and services become more expensive to the rest of the world In addition to the use of monetary policy the appreciation of the franc can help eliminate inflation ii Describe what adjustment occurs if any if both countries ARE part of a currency union Suppose there are two possibilities In the rst case factors of productions are mobile between countries In the second case they are not If factors of production are completely immobile between countries aside from the potential use of fiscal policy there is no adjustment If factors of production are mobile then factors of production including not only labor but physical capital as well will move from Germany to France As workers and other factors of production leave Germany the unemployment rate there declines At the same time the increase in the supply of factors of production in France drives down costs in that country allowing aggregate supply to increase and prices to fall iii Generally what is the primary factor that determines whether or not a currency union is an optimum currency area Is the United States a currency union Why or why not The primary factor determining whether or not a geographic area is an optimum currency area is factor mobility In particular if factors of production are mobile within a currency area then the currency union can absorb asymmetric shocks The United States is obviously a currency area In the United States we employ a single currency It could also be argued that the United States is an optimum currency area since factors of production are highly mobile Class questions April 4 2006 Lecture 18 ECON 3633 900 Reading assignment Chapter 3 Eun and Resnick Chapter 2 lIelvin Note An excellent resource for information about the Asian currency crises can be found on M urieal Roubini s website at the following address http WWW stern nvudu I I 1 Currency crises continued a We discussed at least four reasons especially related to poor economic policy that led to the Asian currency crisis Discuss i ii 39 The liberalization of capital markets in Asia violated to some extent the principles of the trillema Investment in Asia soared driven by high rates of return relative to investments in other countries including the United States The real exchange rate is very likely over valued The had appreciated against the yen while mostAsian countries maintained a fixed exchange rate system Of course Japan was a major trading partner for many countries in the Pacific Rim and thus the currencies throughout the area were over valued relative to the yen The result was a substantial current account deficit for the vast majority of the countries in Asia The existence of crony capitalism is rampant Crony capitalism is a form of capitalism in which there is a strong connection between the government and business leaders In many cases business leaders are appointed by government officials On the financial side many of the loans made because of the liberalization of capital markets turned out to be bad loans that were made with little investigation of the credit worthiness of the applicants or the potential success of the projects for which the money was being borrowed In Korea Indonesia and Thailand the ratio of short term liabilities to foreign reserves is well above I 00 This is of course is untenable and eventually capital ight on a massive scale ensues once knowledge of the poor performing loans and liabilities becomes available b De ne contagion and relate to the Asian currency crisis Contagion refers to the spread of financial turmoil from one country to another often resulting from a currency crisis In the case of Asia the initial devaluation of the Thai baht was quickly followed by a collapse in other countries as well These countries include the Philippines who devalue their peso on July I I Malaysia who abandon their support of the ringgit price of the on July I 4 Singapore who devalue their currency on July I 7 Indonesia who abandon management of the rupiah on August 14 Taiwan who devalue their currency on October 14 South Korea who abandon defense of their exchange rate on November 14 and Russia who are forced to abandon their peg on August I 7 I 998 2 Argentina a Discuss how a currency board such as the one maintained in Argentina Fquot until 2002 differs from other types of xed exchange rate systems As we saw previously a currency board is a separate government agency whose sole purpose is the purchase and sale of domestic currency at the established fixed exchange rate It difkrs from other fixed exchange rate systems in several key ways First the currency board is separate from the central bank and thus the central bank cannot interfere in exchange rate transactions Second the currency board will maintain a large amount of international reserves in an attempt to gain credibility for their peg In many cases the currency board will maintain international reserves that total the equivalent of 100 of outstanding domestic money Thus the use of domestic monetary policy is limited What were the three causes of the Argentine peso crisis as discussed in class i The recession in Brazil that resulted from the Asian currency crisis hurtArgentina since Brazil was a major trading partner of Argentina This lead to a recession in Argentina In response to the recession Argentina employed its only policy option by using expansionary fiscal policy the currency board e quotectively eliminates monetary policy as an option The use of expansionary fiscal policy is financed by an increasingly large government debt In response to the Asian currency crisis Brazil devalues the real In response the Argentine peso is overvalued relative to the real it 39 Class questions March 28 2006 Lecture 1 6 ECON3633 900 Reading Chapter 3 Melvin 1 2 Chapter 2 Eun and Resnick Mexico s economic policies De ne cetes and tesobonos Discuss how Mexico s debt position in 1994 eg its reliance on cetes and tesobonos deepened the crisis that ensued at the very end of 1994 and throughout 1995 Cetes are short term Mexican bonds that are denominated in pesos while tesobonos were short term Mexican bonds denominated in US dollars As pressure built on the peso Mexico attempted to restore confidence by issuing large amounts of tesobonos it is estimated that 70 of government bonds in Mexico were tesobonos by November of 1994 Both are short term government bonds and are thus very liquid In the event that investors begin to lose confidence these short term instruments allow investors to quickly liquidate their Mexican asset holdings As capital ees this continues to place pressure on the peso price of the Further if a devaluation becomes necessary Mexican authorities have essentially increased the magnitude of their debt For instance suppose the peso of the dollar is Ps 350 and suppose Mexico owes 20 billion when the tesobonos mature The debt in pesos when the peso price of the is Ps 350 is Ps 70 billion IfMexico devalues or abandons the peg altogether Mexican debt skyrockets We have seen that the peso price of the dollar spiked to Ps 7 60 byMarch ofI995 At this price the debt stands at Ps 152 billion This debt is untenable and inevitably the IMF and the US had to bail Mexico out as it threatened to default Monetary policy under a xed exchange rate regime a A country that attempts to maintain a successful xed exchange rate system must forego control over domestic monetary policy In many cases however a country with a xed exchange rate attempts to sterilize the ow of international reserves De ne sterilization and relate to our discussion ofthe Mexican peso crisis A country s monetary base consists of international reserves and domestic currency and credit Under a fixed exchange rate system a country must routinely intervene in the foreign exchange market This intervention alters the level of international reserves In the case ofMexico at the end of 1994 the central bank rapidly depleted their international reserves Rather than absorb the contractionary e ects this would have had on the Mexican economy Mexico sterilized the flow of international reserves Sterilization occurs when a country uses domestic monetary policy to offset the e ects of a change in international reserves In the case of Fquot Mexico they employed expansionary monetary policy further causing the peso to be over valued as their international reserves fell De ne the trillema and again relate to the Mexican peso crisis The trillema states that a country can have two of the following but NOT all three i A fixed exchange rate system ii Independent monetary policy iii Free flow of capital In the case of M exico they employed a fixed exchange rate system associated with their crawling band In addition as we have just seen they attempted to maintain control over monetary policy through sterilization Finally Mexican capital markets were highly open and in fact a large portion of the investment in the country by the end of 1994 was in the form of highly liquid short term debt These liquid assets allowed investors to ee the country rapidly known as capital ight 3 Moral hazard and the IMF a Fquot Discuss the role of the IMF and the United States following the collapse of the Mexican peso on December 2022 1994 As we saw Mexican in ation and unemployment sky rocketed following the collapse of the peso on December 22 1994 In response the United States and the IMF approved a bailout package for Mexico that totaled 53 billion De ne moral hazard and relate to your answer in a Moral hazard is the risk that results when an agreement or contract negatively impacts the incentives and actions of one of the contracting parties In the case ofMexico the bailout provided by the IMF may have decreased the perceived costs by other countries who were in similar situations as Mexico In other words if a country employs a fixed exchange rate system the experience of M exico and the IMF may decrease their incentive to adequately pursue the economic policies usually contractionary in nature necessary to avoid collapse Lecture 21 ECON 3633900 April 13 2006 Reading assignment Chapter 5 Melvin Chapter 5 Eun and Resnick 101104 Class questions 1 Consider the following prices S The dollar price of the pound on the spot market F The dollar price of the pound on the forward market for delivery of pounds one year from time t i The annualized interest rate on a 1 year Tbill in the United States i The annualized interest rate on a 1 year Tbill in the United Kingdom Suppose that you are a trader and you observe the following relationship i F 1i2 gt 11 St Describe exactly what actions you would take in the following markets a The domestic market for US treasury bills b The spot market c The foreign market for US treasury bills d The forward market For each market discuss very specifically what is expected to happen to prices in each of these markets as a result of your actions and plausibly other arbitragers as well Ultimately we will lend money in the United States to take advantage of a higher rate of return As the supply of loanable funds increases in the market for US treasury bills the interest rate there will fall Initially we will borrow foreign currency as discussed in part c We will exchange foreign currency for domestic currency on the spot market This action causes the supply of foreign currency to increase The result is a decrease in the spot dollar price of the pound e g an appreciation As discussed above we will start by borrowing foreign currency As we borrow in the foreign market this causes the demand for loanable funds to increase in the United Kingdom The result is an increase in interest rates in the market for US T bills in the foreign country Inevitably we will need to buy foreign currency in the future to pay back the initial amount we borrowed We will lock in at time t to avoid exchange rate risk insuring a profit In other words the Q U 0 3 1 demand for foreign currency in the FOR WARD market increases causing the forward dollar price of the pound to increase 2 You are given the following information i 600 annualized interest rate in the US for an asset maturing in one month i 525 annualized interest rate in Germany for a similar asset maturing in 1 month St 121087 current dollar price of the euro on the spot market Calculate the forward rate associated with the zero arbitrage condition of covered interest rate parity We have the following zero arbitrage condition N N F 1 i 1 i 1 1 S We can easily solve for the forward rate We get 12 E 17 S 3 0193 1i E Now we simply plug in the numbers First we need to adjust the annualized interest rates above such that they correspond to a monthly return We get Z 00612 0005 T 0052512 0004375 Thus the forward rate is simply 1000510004375121087 121162 Class questions March 30 2006 Lecture 1 7 ECON3633 900 Reading Chapter 3 Melvin Chapter 2 Eun and Resnick 1 Consider a US investor who decides to purchase a 3 month Mexican bond The bond is a discount bond selling for a price less than the amount the bond matures at Suppose the purchase price of the bond is Ps 8000 but the bond matures at Ps 10000 Suppose it is September and Mexico employs a xed exchange rate system Mexico does not currently employ a xed exchange rate system Assume that they do for the question The exchange rate in September is Ps 350 i How much interest is earned in dollars if the xed exchange rate system is still in place when the bond matures in January such that the exchange rate remains at Ps 350 The bond must be purchased for Ps 8 000 The US investor must therefore exchange dollars for pesos to purchase the bond To purchase Ps8 000 with the exchange rate of Ps 350 we get Ps 8000Ps350 2285 71 When the bond matures in January we receive Ps 10000 We care about our profit in dollars Therefore we exchange the pesos for dollars We will receive since the exchange rate has not changed Ps 10000Ps 350 285714 So in dollars we paid 2 285 71 to purchase the bond and receive 2 85714 when it matures The total interest earnings 285714 228571 57143 Suppose that the Mexican central bank must devalue the peso in December and then allows the peso to oat Suppose when the bond matures in January the peso price of the dollar is Ps 520 What are the interest earnings or losses in dollars from this investment The amount we pay for the bond has not changed We still pay 2285 71 However when we exchange pesos for dollars in January we will do so at a rate that is not advantageous The amount we receive for Ps 10 000 when the peso price of the is Ps 520 is Ps 10000Ps 520 192308 Given that we paid 2285 71 we actually lose money In this case our loss is39 192308 228571 36263 We therefore lose 362 63 as a result of this investment 2 Mexico s economic policies De ne capital ight and relate to your answer above Capital flight is the rapid liquidation of financial assets in a country that often precludes a currency crisis In relation to the above problem when investors begin to fear a collapse of the peso they will liquidate their assets exchange them for another currency such as dollars and ee Mexico This will likely exacerbate the existing turmoil already in place Class questions March 23 2006 Name Lecture 15 ECON3633 900 Reading assignment Chapter 3 Melvin Chapter 2 Eun and Resnick ANSWERS 1 The real exchange rate a Suppose you are given the following information regarding exchange rates and prices in the United States and Mexico Price Index Mexico Jan 1991 510143 Price Index US Jan 1993 883299 StPeso Jan 1993 033862 Price Index Mexico Nov 1994 758218 Price Index US Nov 1994 982391 StPeso Nov 1994 029048 Using the above information calculate the real exchange rate from the perspective of Mexico for Jan 1991 and November 1994 We want the real exchange rate in Mexico relative to the dollar The real exchange rate in Mexico is M21050 SPeso P R St P Us 2 Therefore for Jan 1993 we have 51014 R 033862 30195568 883299 JAN91 Now for November 1994 we have 758218 R 029048 0229807 982391 JAN93 Fquot From Mexico s perspective has the nominal exchange rate the peso appreciated or depreciated from January 1991 to November 1994 We see that the dollar price of the peso has fallen from 03 3 862 to 029048 Thus the peso has depreciated in value when looking at in nominal terms while the dollar has appreciated C 3 1 Has the real exchange rate from the Mexican perspective appreciated 0r depreciated Explain the difference in your answer relative to part b We see that the real exchange rate has actually increased which means that in real terms the peso has appreciated The peso is now overvalued The rationale is somewhat straightforward Although the nominal value of the peso fell slightly prices increased in Mexico at a much faster rate than they did in the United States If the real exchange rate appreciates in value what is expected to happen to exports An appreciation in the real exchange rate implies that either the price of the peso has increased meaning a depreciation or the relative prices of goods and services in Mexico have increased It is clear that both of these things will cause the demand for Mexican goods and services to decline Thus exports are expected to fall Class questions February 23 2006 Lecture 11 ECON3633 900 Related readings Chapter 2 Melvin Chapter 3 Eun and Resnick 1 The Euro a How did the European Monetary System differ from the European Economic Community The European Economic Community EEC is the pre cursor to the European Union EU while the European Monetary System is the pre cursor to the currency union that exists among 12 countries belonging to the EU The European Economic Community was established under the Treaty of Rome in 195 7 with the primary purpose of eliminating trade restrictions among 6 trading partners in Europe In contrast the European Monetary System was formed in 1979 and is an agreement to more formally co ordinate monetary policy and exchange rate control With the formation of the EMS comes the introduction of the composite currency the European Currency Unit ECU which eventually becomes the euro All countries that are part of the EMS agree to establish a fixed exchange rate relative to the ECU and to maintain their actual exchange rates at 2 25 of the established value Countries that belong to the EEC did not necessarily join the EMS although the members of the EMS were also members of the EEC b Today there are 25 member countries that are part of the European Union i List these countries Countries that employ the euro Austria Belgium Finland France Germany Greece Ireland Italy Luxembourg the Netherlands Portugal and Spain Countries that are part of the ERMII with no immediate intent to join the euro Denmark Countries that are part of the ERMII with immediate intentions to join the euro Estonia Lithuania Slovenia Slovakia Cyprus Latvia Malta Countries that are part of the EU with designs to join the ERMII and ultimately the euro Poland Hungary and the Czech Republic Countries that are part of the EU with no immediate intentions of joining the ERMH or adopting the euro39 Sweden and the UK Since 25 countries are part of the European Union does this mean all 25 countries use the Euro If not list the countries that are not using the Euro One can be a member of the European Union without adopting the euro The countries that are part of the EU but don t use the euro are listed above There are two reasons why one might join the EU without implementing the euro The first reason is that to ultimately adopt the euro a country must be part of the E U first In addition they must ultimately join the ERMH and agree to fix their exchange rates to the euro Furthermore these countries must meet certain convergence criteria before they are allowed to adopt the euro The second reason that a country may join the EU without adopting the euro is far less mechanical Countries such as the United Kingdom and Sweden enjoy the decreased trade restrictions that exist under the EU but have chosen not to adopt the euro as their currency The adoption of the euro would eliminate any role for these countries monetary authorities and would also force the country to lose part of their perceived national identities Further the loss of a country s currency quot 39 a 39 for quot following an economic shock namely the exchange rate Thus the reasons are somewhat political and economic in nature iii Of the countries that are not using the euro but are part of the EU which countries have no stated designs for the adoption of this currency Again these countries are listed above Sweden and the UK Class questions January 24 2006 Name Lecture 2 ECON 3633900 1 Suppose a trader obtains the following quotes in the following market Paris 0976l09766 NewYork l5267l5272 Amsterdam l5570l5580 a Does an arbitrage opportunity exist Suppose you start with 10000 Indicate exactly how much pro t you would make Show all of your work To determine ifan arbitrage opportunity exists we start by picking any two markets and then determining what the implied rate should be in the third market If the quotes di quoter and they DO NOT OVERLAP an arbitrage opportunity exists Suppose I pick the Paris and Amsterdam markets I wish to use these two markets to calculate the implied price of the Notice that if I multiply an exchange rate whose unit of measure is by an exchange rate whose unit of measure is then the result is an implied exchange rate whose unit ofmeasure is Thus I can multiply the bid rates in Paris and Amsterdam by each other to get the bid rate for expressed in The result Bidpricefor 09761 I5570 15197877 I can do the same thing for the ask price Askpricefor 09766I5580 15215428 Thus the IMPLIED bid ask spreadfor the is 15197877 15215428 These quotes yield the rate at which I can buy and sell indirectly by going through the Paris and Amsterdam markets Notice I can purchase a indirectly at 15215428 and sell it directly in New Yorkfor 15267 the is overvalued in New York since ityields more than it should There is an arbitrage opportunity If I have I must acquire and then sell them in the New York market where they are over valued I thus exchange for in Paris then exchange the for in Amsterdam Finally I sell the s in New York for Although we determined this course by starting with two different markets than we did in class the results are precisely the same To be precise suppose we start with 10000 We proceed as follows Sell I 0 000 for in Paris We use the ask rate here since we the bank is selling us euros This yields 1000009766 67023961 Sell 1 0 239 61 forpounds in Amsterdam Again since the bank is selling us and this is the market for we use the ask rate In this case we get 10239 61 15580 6572 28 Finally we exchange pounds for dollars in New York Since we are selling pounds in the market for pounds e g the bank is buying pounds the relevant rate is the bid rate This yields 65722815267 1003389 Thus we make aprofit of3389 Class questions January 26 2006 Name Lecture 3 ECON 3633900 1 Suppose you Visit a casino in Las Vegas and they provide the following quote in the market for dollars 08340 08350 Based on these quotes calculate the bid and ask prices in the market for EUROS If we are referring to the market for euros based on the quotes above then we know that the price is the dollar price of the euro Refer to the first number in the quote above This tells us the number of euros the bank will SELL us if we give them 1 This rate therefore tells us something about the ASK price in the market for euros Thus the ask price in the market for euros is ask 108340 119904 Similarly the bidprice in the marketfor euros is one over the ASKprice in the market for dollars Bid 108350 119760 Notice that the bid price will ALWAYS be less than the ask price N According to CNNcom on Thursday January 26 2006 In currency trading on Thursday the dollar bought 11638 up from 11574 on Wednesday a Has the dollar appreciated or depreciated Explain The quotes given above are indirect quotations from the US perspective The indirect quotations have risen and thus the dollar has appreciated in value e g we can purchase more yen with a single dollar than we could before 39 h p uuudl Reserve is set to increase their target on the Federal Funds rate Below plot the effects in the market for dollars After mg Federal Reserve mmam then targztmr mg Fed mm mtg want to pmhm 03mm whxch wxll yield a mth msz rate Ta purchmz 03mm Japanzsz Investors nzed dollars Ms W demand U D to 2L7 maremz scann Yenll637 7777777777777777777777 Yen us 74 Interest rates Q m foryen Be sure to carefully list the exact currency prices ohyour graph In the market for yzrl the supply ofyerl marszs Th1 occurs Japanzsz mmtors exchange yzrl for d0llars so they can wchasz US msets The 27252 are dzplctzd bzlow M72152 that mlgmally the dollar prlcz ofch yzrl IS 5000864 butfalls to 50008593 scani si 52 SD 864 SD 8593 i l Di 1 Q Q2 Q af 1 mil p i simply describe without using the graph above 4 US could o2 harmed The Federal Reserve rhoy d2le to attempt ah lrltzrvzrltlml Wlth ah lrltzrvzrltlml they would llkz tofmcz o dzprzcmtlml ofch dollar whlch results m ah apprzcmtlon 0fth2y2rl me above the Thls z zctlvzly mcrcdm the dzmarld for ych Lecture 23 ECON 3633900 April 20 2006 Reading assignment Chapter 5 Melvin Chapter 5 Eun and Resnick 101104 Class question 1 Consider a hypothetical trader in the Switzerland who owes 120000 in 90 days The Swiss trader cares about her wealth only is SF The Swiss trader has determined that there are two unique cases of the world There is a 50 chance that in 90 days the price of the SF will be 075 and there is a 50 chance that the dollar price ofthe SF will be 125 a What is the expected future spot rate and what is the expected amount the trader will pay in 90 days in SF The future exchange rate is simply given by 12 0 75 12 125 1 00 The expected amount the trader will pay in SF is 120 000 1 SF 1 20 000 Fquot The trader is risk averse and has only SF 200000 in her account The trader is concerned with the amount she will have left over after the transaction The trader derives utility from her wealth given by the following utility function W wlZ Based on your example above what is the trader s expected utility from using the future spot market to carry out this transaction the number you use for wealth here is the amount left over from the SF 200000 the trader has after the transaction The trader starts out with SF 200 000 She must pay 120000 in 90 days If the future exchange rate is 0 75 she will pay 120 0000 75 SF 16000000 If this is the case then the trader will only have SF 40 000 left after the transaction If the exchange rate is 125 then the trader will pay 120000 125 SF 96000 In this case the trader will have SF 1 04 000 left over The expected utility is therefore 050 40000 2 050104000 2 26124515 C 3 1 D How much would the trader take for certain that would give her exactly the same utility as your answer in b We are looking for the value of wealth that yields a utility level equal to 26124515 We solve w 26124515 gt w 261245132 gt w SF 68 249 03 If the trader had access to a forward contract what forward rate would yield the amount of wealth in part c Ifwe have SF 68249 03 left over this means we had to pay SF 13175097 to consummate the transaction The forward rate would solve the following 120000F SF13175097 1gt F 120000131 75097 1gt F 09108 Is the forward rate equal to the expected spot rate If not does this mean people are irrational Explain From above the forward rate is less than the expected future spot rate In this case the trader is willing to pay more SF with certainty rather than to expose themselves to risk In other words the worst case scenario is that the trader could have to pay SF 160000 ifthe future exchange rate is low To avoid this risk the trader will lock it at a lower forward rate than what they expect the spot rate to be even though this means she will have to pay a little more than she would be expected to without the contract The trader is not irrational Class questions February 9 2006 Lecture 7 ECON 3633 900 Reading assignment Chapters 2 and 3 Melvin Chapters 2 and 3 Eun and Resnick 1 Understanding the role of of cial reserves Consider a country similar to the former situation in Mexico that employs a xed exchange rate system a Fquot Suppose speculators attack Mexico by selling short Mexican Pesos a situation under which investors borrow pesos sell pesos for and lend Describe what happens to the capital account in Mexico ignoring of cial reserves and of cial reserves As foreign borrowing increases in Mexico the Mexican non o icial reserve component of the capital account will go into de cit a Mexican loan to a foreign entity is an asset from the Mexican perspective since the foreign entity owes money to the Mexican bank With a fixed exchange rate system no other adjustment will occur To offset the deficit in the capital account Mexico will have to run a surplus in their ojficial reserve account They do so when the Mexican central bank supplies dollars in the foreign exchange market thus depleting their holdings of of cial reserve assets in this case US dollars How are speculators successful in attacking a precarious xed exchange rate system Speculators will attack precarious exchange rate systems when they believe that the central bank can not continue to support the peg given their holdings of of cial reserve assets Take for example Mexico who was successfully attacked in 1994 When speculators began to believe that Mexico did not have enough dollars to support the dollar price of the peso in 1994 they began attacking the peg using the actions in part a The speculator is successful when the Mexican central bank depletes their holdings of dollars and the Mexican central bank is forced either to devalue change their peg to a higher peso price of the dollar or to abandon the peg altogether allowing the peso price of the dollar to skyrocket 2 The Twin De cits Using the expression we derived in class list the three ways in which a current account can go into de cit or into further de cit Recall that we derived the following expression awn 173 G T When imports exceed exports M X is positive There are three ways from national income accounting using the above equation that M X can increase a Private investment 1 increases which would likely represent a surplus in the capital account b Domestic savings S could decrease c The budget deficit G T could increase Class questions April 6 2006 Lecture l 9 ECON 3633900 Reading assignment Chapter 4 Melvin textbook pages 6972 Chapter 4 Eun and Resnick textbook pages 9094 1 What are the three main aspects of the forward market The main aspects of a forward contract are as follows a b c The forward market is a decentralized market In other words trades occur through individual banks and their customers and there is not a centralized exchange Thus the nature of a forward contract is idiosyncratic and depends on the buyer and seller Thus a forward contract can be much more specialized than the other hedging instruments we will consider There is no specific settlement date The contract can be written for any currency the parties agree to 2 Refer to the handout administered in class from the Wall Street Journal a Fquot 0 Consider the market for Japanese yen From the US perspective what is the direct quotation for the Swiss francl month forward The direct quotation is F1M0 7815 What is the direct quotation for the yen on the spot market If we believe that the forward rate is a good predictor of the spot rate one month from now do we expect the to appreciate or depreciate Explain The direct quotation on the spot market is S0 7790 Note that the future price of the Swiss franc yen as re ected through the forward rate is greater than the current spot rate Because the price in the future is expected to be greater than the price of SF today it could be said that markets anticipate that the will depreciate in value Calculate the annualized forward premium or discount on the SF and explicitly state whether the SF is selling at a discount or a premium The annualized forward premium is given as 3M E S 200 07815 07790 S 07790 Clearly the SF is selling at a forward premium 1200 3851